Financial Institutions and Economic Development

The presentation discusses different ways that the financial sector can contribute to economic growth. It further discusses other dependencies to economic development.

1. THE GROWTH OF THE FINANCIAL SECTOR HAS A POSITIVE IMPACT ON THE ECONOMIC DEVELOPMENT OF A COUNTRY. FINANCIAL INSTITUTIONS Presenter: P. Mabamba-2019 1

2. DEFITION OF TERMS Jurek (2014) defines financial institutions (FIs) as those firms engaged in the business of dealing with financial and monetary transactions such as deposits, loans, investments and currency exchange. The financial sector is a section of the economy made up of firms and institutions that provide financial services to commercial and retail customers. This sector comprises a broad range of industries including banks, investment companies, insurance companies, and real estate firms ( Aizenman, Pinto & Sushko , 2013 ). Economic development is the process by which a nation improves the economic, political, and social well-being of its people. Presenter: P. Mabamba-2019 2

3. DEFINITION OF TEMS (cont..) Whereas economic development is a policy intervention endeavor with aims of improving the economic and social well-being of people, economic growth is a phenomenon of market productivity and rise in GDP . Consequently, as economist Amartya Sen points out, "economic growth is one aspect of the process of economic development“ Indicators of economic development: BNP per capita; Population Growth; Occupational Structure of the Labor Force; Urbanization.; Consumption per capita; Infrastructure; Social Conditions; literacy rate; life expectancy; health care; caloric intake; infant mortality etc Presenter: P. Mabamba-2019 3

4. FINANCIAL SECTOR & ECONOMIC DEVELOPMENT Development of insurance and banking institutions is one of the crucial elements that plays an important role in stimulating financial development and thereby the growth of the economy (e.g ., Patrick 1966, Sandberg, 1978; Levine, 1997). Asserting the importance of financial intermediaries, Schumpeter (1911 ) argued that the services provided by them are crucial for economic development. Analyzing the same relationship for 10 developing countries Christopoulos and Tsionas (2004), find causal relationship from financial development to economic growth in the long run . A strong financial sector includes banks , investment companies, insurance companies, and real estate firms, and these are central in promoting economic growth through provision of resources for industrial exapansion . Presenter: P. Mabamba-2019 4

5. FINANCIAL SECTOR & ECONOMIC DEVELOPMENT Researchers have suggested that the relationship between financial development and economic growth depends on the level of economic development in the country. For example, Liang and Reichert (2006) find that the causality between financial development and economic growth changes with the change in economic growth cycle . At some level it is “demand following” while at some other level it is “ supply led .” For the developing countries the causality shows “ demand following ” relationship while such results for the developed countries were found to be weak. Presenter: P. Mabamba-2019 5

6. FINANCIAL SECTOR & ECONOMIC DEVELOPMENT he empirical study by Arena (2008) finds that economic growth is positively and significantly affected by insurance activity. The findings show that life insurance has a significant effect on economic growth only on high income countries. Haiss and Sumegi (2008) also find positive impact of life insurance on economic growth of European Region countries that include Switzerland, Norway and Iceland. Similar results are also found by Curak et al. (2009) where using the data of 10 transition EU countries, they have found that economic growth is promoted by development in the insurance sector Presenter: P. Mabamba-2019 6

7. FINANCIAL SECTOR & ECONOMIC DEVELOPMENT The impact of financial sector in economic growth is considered vital for the economies as the financial sector or intermediaries play an important role in mobilizing the funds “to the highest-valued users in the economy” ( Greenwood, 2013). According to Levin (2004) in Zhuang et.al., (2009) the countries with well developed financial sector services tend to grow faster as they can invest more and thus reap more. a financial system that is well-developed stimulates growth by channeling savings to the most productive investment projects. Conversely, financial repression results in poorly functioning financial system that in turn depresses growth. Presenter: P. Mabamba-2019 7

8. THE ROLE OF THE FIANCIAL SECTOR IN ECONOMIC GROWTH The promotion of development needs a sufficient amount of capital stock and profitable investment that guarantees a sustainable growth in the economy – thus, growth in the financial sector is a prerequisite of economic development. A stable financial sector enables savings, and the necessity of savings for economic growth is linked with their effectiveness in financing capital accumulation and therefore increasing investments (Pagano, 1993). Ideally, the banking sector develops to serve as an efficient intermediary between depositors and investors, generating market-clearing prices and interests rates, and these are indispensable in economic growth through revenue accumulation. According to Bencivenga and Smith (1991) the beneficial activities of banks are accepting deposits, lending thus eliminating the need for self financing. Presenter: P. Mabamba-2019 8

9. THE ROLE OF THE FIANCIAL SECTOR IN ECONOMIC GROWTH Banking sector development can also be measured by the margin between lending and deposit interest rates and by the percentage of non-performing loans in the economy. This is because both are significantly and negatively related to economic growth as non-performing loans describe the quantity and quality of information that the banking sector has collected and analyzed which in turn affects its lending to investors . The World Bank (2001) cited empirical studies, which strongly suggested that improvements in financial arrangements precede and contribute to economic performance. Presenter: P. Mabamba-2019 9

10. THE ROLE OF THE FIANCIAL SECTOR IN ECONOMIC GROWTH The financial system is also particularly important in reallocating capital and thus providing the basis for the continuous restructuring of the economy that is needed to support growth . Looking back more than one century ago, during the Industrial Revolution , it’s observable that England's financial sector did a better job in identifying and funding profitable ventures than other countries in the mid-1800s. This helped England enjoy comparatively greater economic success. he banker and former editor of “The Economist” Walter Bagehot expressed this in 1873 as follows. ‘In England, however, ... capital runs as surely and instantly where it is most wanted, and where there is most to be made of it, as water runs to find its level.” Presenter: P. Mabamba-2019 10

11. THE ROLE OF THE FIANCIAL SECTOR IN ECONOMIC GROWTH Bank-based finance has a special role to play for many companies in need of funds, and thus helps to ensure a well-balanced growth process . Banks can contribute to alleviating the impact of sudden economic shocks on their clients . Banks stand ready to provide many customers with funds even in adverse circumstances, e.g. when the liquidity of financial markets dries up . However, if the financial sector is not developed enough, lending becomes compromised hence increases the risk of financial shocks on many firms. Thus disrupting the positive developmental trajectory of a country. Presenter: P. Mabamba-2019 11

12. THE ROLE OF THE FIANCIAL SECTOR IN ECONOMIC GROWTH Also the design of prudential regulation plays an important role from a growth perspective . Supervision is the guardian of financial stability, which in turn crucially determines the capability of the financial system to allocate resources efficiently and absorb liquidity shocks. The collapse of the Zimbabwean financial sector in 2008 led to a failed economy as all forms of trade came to a standstill. Also, a weak financial sector in Zimbabwe led to the “ disappearance ” of 15 billion. Such porous and leaking financial sectors are a liability to the economic development of a country. Presenter: P. Mabamba-2019 12

13. THE ROLE OF THE FIANCIAL SECTOR IN ECONOMIC GROWTH A developed financial sector allows money exchange which leads to accumulation of foreign currency through remittance inflows and these contribute immensely to economic development. Remittances made up between 11-15% of Zimbabwe’s GDP in 2011. such figure as R6.8 Billion (about US$847 million) is a significant input into the economy. Remittance inflows started to increase around 2008 when the financial sector made significant improvements which Mukuru , Ecocash Diaspora, and World Remit coming into play. Presenter: P. Mabamba-2019 13

14. THE ROLE OF THE FIANCIAL SECTOR IN ECONOMIC GROWTH Financial sector development may be an essential prerequisite for economic growth, since well-functioning markets and financial institutions may reduce the transaction costs and asymmetric information problems. At the same time, financial institutions play an increasingly pivotal role in identifying investment opportunities, selecting the most profitable projects, mobilizing savings, facilitating trading and the diversification of risk, as well as improving corporate governance mechanisms . An efficient financial sector positively affect economic growth through the efficient allocation of resources to the most productive users. Presenter: P. Mabamba-2019 14

15. COUNTER ARGUMENT Presenter: P. Mabamba-2019 15

16. DEPENDENCIES A strong financial sector alone is not sufficient to drive economic growth. Strong institutions and effective investment policies are equally indispensable in driving economic growth. Borrowing constraints and growth will ultimately depend on the importance of the effect of borrowing constraints on the marginal productivity of capital relative to their effect on the volume of savings . It could be argued that the roles of banks in economic growth of countries are limited especially in developing economies where imperfect information exists . Presenter: P. Mabamba-2019 16

17. DEPENDENCIES It could be argued that the roles of banks in economic growth of countries are limited especially in developing economies where imperfect information exists. The paradigm of asymmetric information between borrowers and lenders offers valuable insights into the forms that finance is likely to take; as it will determine who will be able to obtain finance, from whom and under what terms and conditions. This process will severely limit access to funds for those who need it and thus slow the rate of economic activities. Thus , banks engage in credit rationing to compensate for this risk by imposing higher prices on borrowers which discourages borrowers with worthwhile investments from seeking loans, thereby worsens the rate economic activities in the country. Presenter: P. Mabamba-2019 17

18. DEPENDENCIES In effect the role of banks in economic growth is severely limited as credit rationing discourages a pool of borrowers which undermines the markets. Presenter: P. Mabamba-2019 18

19. CONCLUSION To come to a general empirical conclusion, we can say that studies using cross sectional regressions found out that financial developments positively affect economic growth through productivity of capital and accumulation of saving, though they however failed in explaining the real direction of causality between financial development and economic growth . Presenter: P. Mabamba-2019 19

20. THANK YOU SIYABONGA THE END Presenter: P. Mabamba-2019 20